Marijuana Stocks Could Be a Buzzkill

A cold rain beat down recently on the boarded-up cinder-block homes and empty factories of Smiths Falls, Ontario, melting the last snows in this industrial town about an hour south of Ottawa. One parking lot was full, however. Inside a shuttered chocolate factory, it is artificial summer for the marijuana crop of the largest cannabis company in the world, Canopy Growth.

In brightly lit, high-tech “grow rooms,” Canopy is preparing for the expected legalization of recreational cannabis this year in Canada—the first industrialized nation to do so at the federal level. Workers in lab coats harvest, trim, and package Canopy’s Tweed-brand products, then store them in a giant vault whose heavy door would do a bank proud.

It is a scene being repeated by companies across Canada, which wants to become the Silicon Valley of recreational pot.

Canada’s experiment is being closely watched by other countries, including the U.S., where federal law still classifies marijuana as an illegal narcotic, but where more than half of the states allow prescription sales and nine have legalized recreational use. The visitor log at Canopy’s Smiths Falls facility shows delegations from dozens of countries.

As they often do, investors have celebrated this emerging business early by embracing Canadian companies that claim a cannabis connection. Traveling in Canada, cabbies, bankers, and even border guards will tell you their favorites in a bubble that has floated Canadian cannabis stocks to a collective stock-market value above $30 billion. That’s already about half the market capitalization of Canada’s gold mining industry.

But a Canada weed glut is a real risk. At current valuations, marijuana stocks are already too high for an investor tempted to join the party.

If other large nations follow Canada’s lead, cannabis could become a consumer discretionary business on the scale of the alcoholic beverage industry, in the view of
Constellation Brands
(ticker: STZ), the U.S. beer and wine giant that just plunked down $191 million for a 10% stake in Canopy. Constellation recently told analysts that global sales of cannabis products could reach $200 billion in 15 years.

Even under America’s conflicting regulations, Constellation says, U.S. cannabis sales already generate $50 billion annually, versus $60 billion for wine and about $75 billion for tobacco. Canopy’s chief executive, Bruce Linton, is confident that his product can compete against booze. “Mine doesn’t make you fatter or hung over,” he tells Barron’s. “And it leaves you feeling giddy afterwards.”

When Canada’s recreational sales start,
Canopy Growth
(WEED.Canada) will be ready with an Amazon.com-like e-commerce site called tweedmainstreet.com, featuring company brands like Tweed or Leafs by Snoop (yes, as in Snoop Dogg), as well as small-batch specialties from “craft” growers.

Linton and his rivals expect that nonsmoking forms of cannabis will fast become popular in Canada, as they have in markets such as Colorado. Extracts suited for vaping or munching can deliver the weed’s active ingredients like tetrahydrocannabinol, or THC (the source of a marijuana “high”), and cannabidiol, or CBD (which soothes pain in cancer patients). Food scientists at Canopy’s Smiths Falls plant are spending Constellation’s money to develop edible and potable products, including nonalcoholic, THC-fueled versions of beer, gin, and vodka. These consumable forms of cannabis, however, won’t be allowed until 2019 under Canada’s proposed law.

Along with Canopy, Canada is home to three other leaders in cannabis, all with sprawling greenhouses or high-tech grow houses like those in Smiths Falls. They are
Aurora Cannabis
(ACB.Canada),
Aphria
(APH.Canada), and
MedReleaf
(LEAF.Canada).

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Vivien Azer of Cowen & Co. is the only analyst on Wall Street who covers cannabis stocks. After seeing Colorado’s legal cannabis dispensaries, she put out Buy recommendations for Canopy and MedReleaf. A longtime analyst of the beverage industry, Azer thinks that legalized cannabis could eventually substitute for much of alcohol’s role as “a social lubricant.”

Still, the price of Canada’s marijuana stocks might trigger vertigo. These companies trade for more than 100 times their 2017 sales, and several hundred times that year’s cash flows. Some have market values that are larger than estimated sales for Canada’s entire recreational marijuana market.

If Canada’s retail market can reach $9 billion in annual sales in a few years—as one bull estimates it will—that would yield only a couple of billion dollars in cash flow to wholesale producers like Canopy. So today’s investors are effectively paying 15 times the industry’s cash flow five years from now, a generous multiple. Moreover, there’s reason to believe these revenue forecasts are overly optimistic.

Most predictions fail to consider the dizzying price drops registered in states like Colorado and Washington after they legalized marijuana. In both states, supply gluts have pushed cannabis prices down more than 10% in each of the past two years.

Canada’s leading cannabis companies are “licensed producers” that make most of their money growing marijuana. Canadian investors have given them enough dirt-cheap capital to build more production than the world has ever seen, for a market already well-supplied by illegal growers. Once all the new greenhouses start budding, Canadian weed prices might tumble.

The Canadian companies will have to get through a price shakeout, says Jonathan Rubin, who has tracked U.S. spot prices for several years at New Leaf Data Services, a Stamford, Conn., pricing outfit that hopes to establish the cannabis benchmark. “You’ll hear folks who say that cannabis is different, that it’s not a commodity. Everyone wants to be the Coors of cannabis.”

Those Coors wannabes know that Canada’s recreational cannabis use is among the highest in the world. A 2013 report by Unicef said consumption by Canadian teenagers was the highest for that age group in any developed country. A 2015 report by Toronto’s Center for Addiction and Mental Health said that 45% of Ontario adults had used cannabis at least once, while about 15% acknowledged using it in the past year. And since 2001, Canada has let dispensaries sell marijuana by prescription. In British Columbia, Vancouver has so many dispensaries and lounges that some call it Vansterdam.

Nearly a year ago, the government of Prime Minister Justin Trudeau proposed a bill that would broadly regulate the production and sale of cannabis for recreational use by adults, with a target date of July 1, 2018. While the House of Commons approved the measure, Conservative members of the Senate have slowed its advance; it’s unlikely to become law before September.

The big four weed companies in Canada are gearing up for what they hope will be a large market for recreational use, but they all have gotten their starts as licensed producers of medical marijuana. Their customers get a doctor’s prescription and then register with one of the producers for mail-order delivery.

Neil Closner was an executive at Mount Sinai Hospital in Toronto when investors asked him to go into the medical marijuana business. “I was highly skeptical,” he recalls. But a visit with nursing home patients in Israel left him impressed with the ability of cannabis to relieve suffering from Parkinson’s disease, epilepsy, and cancer. In 2013, Closner helped start MedReleaf and became its chief executive. It now supplies more than 20% of Canada’s prescription cannabis.

In an industrial park near Toronto recently, Closner donned a surgical gown, mask, cap, and slippers to lead a tour of MedReleaf’s flagship plant. Except for the guard in a bulletproof vest, the building is typical of a conventional pharmaceutical operation, with air locks, vent ducts, and sealed doors. Step into a grow room, however, and you’re bathed in yellow light and a certain pungent smell. Green, jagged leaves rise like a forest of miniature Christmas trees, gently swaying under buzzing fans. After 10 weeks under the lights, the plants think it’s summer, and their thick buds turn the room into a two-foot tall jungle.

Licensed producers like MedReleaf are experimenting with cannabis cultivation on a huge scale. A greenhouse-grown crop yields 75 grams of dried flower per square foot, Closner says, but MedReleaf’s high-tech grow house yields 300 grams per square foot. Clean-room precautions keep out mold, mildew, and male pollen. That’s crucial, because every plant in the place is a cloned female and any pollen would make them all go to seed.

At its recent share price of C$17 ($13), MedReleaf’s stock values the company near C$2 billion. It had all of C$11 million in December-quarter sales, with losses of C$5 million, or five cents a share. Until the current fiscal year, MedReleaf had profits and operating cash flow (if you overlook the expense of stock options), but that is changing as it spends to gear up for legalization. The company is buying a million-square-foot greenhouse that will quadruple production.

MedReleaf hopes to establish medical cannabis production in foreign markets, including Germany, where pharmacies prescribe it and health insurers pay for it, unlike in Canada. The international opportunity is why the stock flies so high, CEO Closner says. “The valuation of our industry in the stock market reflects a level of enthusiasm and optimism about the world market,” he says, “which I think is warranted.”

Back in Smiths Falls, Canopy is doubling its output. Already the biggest producer in Canada, it got approval in February to build the world’s largest federally licensed cannabis site, in British Columbia. That will help expand its Canadian growing space to 5.6 million square feet. Over a February weekend, it flew 100,000 live plants to British Columbia in specially built crates.

At a recent stock price of C$33, the market values Canopy at nearly C$7 billion. Its revenue doubled in the December quarter, reaching C$22 million. Some 23% of those sales were cannabis oil and gel caps. Although Canopy showed net income of C$11 million, or one cent a share, the profits resulted from accounting gains. The company actually lost C$26 million on operations for the period and had negative free-cash flow exceeding C$100 million after all its investments for growth. CEO Linton says he wants to ensure that when recreational sales start, his products are on the shelves.

Investors are happy to help. At first, Canada’s biggest banks shunned the cannabis trade, so growers got loans from credit unions and sold stock through small brokers, such as GMP Capital of Toronto and Canaccord Genuity of Vancouver. But recently, the Bank of Montreal’s BMO Capital Markets joined GMP to help Canopy sell a C$200 million stock offering. Like most Canadian cannabis offerings, the shares were easily sold to both retail and institutional investors.

Investors’ money is funding a lot of production. Vancouver’s Aurora Cannabis brags that it grew to Canopy’s size in half the time. Aurora says it is building the world’s largest cannabis greenhouse, next to the airport in Edmonton, Alberta. And a joint venture will erect Europe’s biggest cannabis facility, in Denmark.

Revenue tripled in Aurora’s December quarter, to C$12 million. The company reported net income of C$7 million, or two cents a share, but that was a result of some investment gains. On operations, Aurora lost C$16 million. At a stock price of C$9, the market values the company at C$4.5 billion.

Aurora is sufficiently hungry that it began the industry’s first hostile takeover, in November, for a Saskatchewan producer called
CanniMed Therapeutics
(CMED.Canada). The board of CanniMed came around in January, after Aurora raised its offer from C$24 a share to C$43 in cash and stock—a total of about C$1 billion, 60 times unprofitable CanniMed’s 2017 sales.

The free-spending ways of other licensed producers is a favorite topic of Vic Neufeld, the chief executive of Aphria. In reporting quarterly sales of C$9 million, Neufeld noted that it had been Aphria’s ninth consecutive quarter with positive cash flow—in this case, C$1 million. The Toronto company says it aims to be a low-cost producer by sticking with greenhouses, instead of the more expensive indoor facilities.

That’s not to say that Aphria has stayed on the sidelines as its rivals spend investors’ money. It recently agreed to buy a company called
Nuuvera
(NUU.Canada) for about C$500 million in cash and stock. Nuuvera’s total sales over nine months were just C$30,000.

Like Canada’s other cannabis producers, Aphria has a market cap (C$2.4 billion) that seems out of proportion to its historical sales. To guess these companies’ fair value, it makes sense to look ahead to what the industry might look like after recreational sales kick in.

One analyst who has studied that opportunity is Daniel Pearlstein of Eight Capital, a tiny Toronto brokerage firm. He’s a bull, convinced that cannabis presents investors with a once-in-a-lifetime chance to get in on an industry that will boom like the internet.

“This is a market that is simply way bigger than a lot of people believe,” he contends.

How big? About $9 billion a year, Pearlstein estimates. Colorado has a sixth of Canada’s population, he notes, and the state’s cannabis sales reached $1.5 billion in its fourth year of legalization. So Pearlstein multiplies Colorado sales by six. And, of course, there are countries with potential markets bigger than Canada’s. Pearlstein believes that federal legalization gives the U.S.’s northern neighbor a head start to becoming the world’s preferred supplier.

Cowen analyst Azer is as optimistic as Pearlstein, although she worries about pricing, as legal weed finds a balance between supply and demand.

She’s right to worry.

Rubin’s New Leaf Data Services has a Cannabis Benchmarks index, which tracks weekly spot prices in more than a dozen markets, including Colorado, Washington state, and California. The volume-weighted index found that in states where weed is legal, spot prices dropped 20% over the course of 2016. The average in 2017 was 13% below 2016’s.

Prices were stable in the first year or so of legalization in Colorado and Washington, while supply caught up with demand. But then, cannabis behaved like other crop commodities; prices dropped in a supply glut. Canada’s market should also be well-supplied. There were four licensed producers when Health Canada began handing out licenses. Today, there are 94.

The potential for a supply glut is underscored by the claims of many producers that they are each building the world’s biggest grow house.

Neil Closner, MedReleaf’s chief executive, touring his company’s growing facility in Markham, Ontario. “The valuation of our industry in the stock market reflects a level of enthusiasm and optimism about the world market,” he says, “which I think is warranted.”
Nathan Denette/The Canadian Press via AP

In February,
Cronos Group
(CRON) became the first Canadian grower to list shares on a U.S. exchange. At a recent $6.73, the Nasdaq-traded stock values the company at $1.1 billion, even though it had only C$3 million of sales in the 12 months ended September. That may explain why Cronos’ latest investor presentation shows no financial results--though it does say that it is building a 286,000-square-foot grow house that is “expected to be the largest purpose-built indoor cannabis production facility in the world.”

All these giant greenhouses won’t just compete with one another, of course. By some estimates, North America’s black market for marijuana is worth more than $50 billion a year. A study done for California by ERA Economics concluded that, in 2016, the state’s cannabis suppliers sold $1 billion worth to legal users and over $20 billion to illegal customers—mostly out of state.

One of Prime Minister Trudeau’s main legalization aims is to take sales from Canada’s estimated C$7 billion black market (and generate tax revenue in doing so). But that will take years, because black market incumbents won’t give up without fighting back by discounting their prices below those of the legal stuff.

Walk around certain neighborhoods of Vancouver or Toronto, and it’s hard to avoid passing a cannabis dispensary. Some require a prescription; some don’t. Strictly speaking, they’re all illegal. Websites also make it easy to arrange home delivery, and pop-up street fairs are common and hard to police, however illegal.

On an East Toronto street recently, the milling crowd made it obvious which door to try. Every minute or so, the dispensary’s manager buzzed in another group of young adults. A scruffy counter in the back of the undecorated space held the goods. The household furniture completed the low-rent look.

The shop’s manager, a cancer survivor, was furious that Ontario’s legalization plans leave out the pioneers of the cannabis trade. The manager, who asked not to be named because of past litigation, predicts that the black market will fight back by pricing its products at C$6 a gram, while the legal stores charge C$10.

Canada’s legal producers will have another pricing headache: The most populous provinces will allow retail sales only through government stores operated by provincial control boards. So in Ontario and Quebec, licensed producers will have just one large customer, which will dictate what they are paid.

Neufeld, the Aphria CEO, has warned that prices paid by these government stores will disappoint the industry’s high-cost growers. Talking on his last earnings call about his new contract with Quebec, he argued that “what they’re willing to pay licensed producers is absolutely going to force compression in pricing and therefore margins.”

From his study of the legal cannabis markets in Colorado and Washington, Rubin of New Leaf Data Services expects Canada’s recreational users to be uninterested in paying up for premium brands. He says the two questions he mainly hears in those states’ stores are: “What’s most potent?” and “What’s on special?”

Neufeld, in talking up Aphria’s focus on costs, scoffs at the exuberance he sees in his industry. Some licensed producers, he says, “are stating that it will be impossible not to make money once the recreational markets open up.”

But, he adds, “L.P.s that haven’t made profits while scaling up will continue to burn cash and ultimately disappoint investors.”

Tell us what you think: Is Canada’s approach to marijuana a model for the U.S.? Would you invest in pot stocks? Write us at mail@barrons.com and we may publish your take. Find out more at barrons.com/mailbag.

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